I'd Like a "V" Please

Good Morning. With stocks having finished higher for three consecutive sessions and the Dow having spiked nearly 475 points since Monday's low, it is fair to say that the bulls are at least back in the game. However, before we ring the bell indicating that it's okay to get back into the pool, the key question that needs to be answered is whether or not we will see a retest of the lows before anything good can happen again.

Put another way, the issue at hand is if the bottom of the current corrective phase will take the shape of a "V" or a "W". In my experience, "V" bottoms are more typical of garden-variety pullbacks and/or news-induced panics. On the other hand, a "W" bottom is generally associated with more protracted and more severe corrections. For example, the summer swoons of 2010 and 2011 were long, drawn out affairs in which the initial lows were tested and retested while the two corrections in 2012 can be placed in the "V" camp.

So, which is it going to be this time around? As always, I have to point out that I do not own a functioning crystal ball and I am not a discretionary trader/investor. No, I prefer to use rules and a process-driven approach to my exposure and buy/sell decisions. However, I am not against attempting to objectively analyze situations in the market from time to time.

Arguments for a "W" Bottom

First of all, the current correction on the S&P 500 has exceeded the -5% level (-5.76% to be exact). And on a global basis, the declines have been more significant as the MSCI All Country World Index is off 8% and 10 countries have seen declines of more than 15%. In short, this means that we have got something a little more meaningful than your run-of-the-mill pullback on our hands.

Next, instead of a violent reaction to some event, the current correction got rolling in response to an overextended rally. In other words, there wasn't any one trigger or catalyst to the move. This tells us that the move began as a consolidation and then morphed into something more when all the "taper talk" started.

What we would expect to see from here is for the current bout of volatility to continue for a while longer before receding. From a price perspective, the typical bottoming process involves making an emotional low, which is then followed by a rebound, and then ultimately, another decline to "retest" the lows.

After the initial rally off the lows, the reason behind the decline typically reasserts itself, thus producing the retest or "double bottom." And while this correction didn't start with a catalyst, we do have to recognize that the "taper talk" was responsible for the majority of the decline last week.

After the retest of the lows, which may or may not be successful, volatility as well as volume tends to dry up and things get "quite" for a while. From there, the bulls usually find a way to start moving higher again.

Arguments for a "V" Bottom

From my perch, it looked like the current correction began in a constructive fashion. There wasn't any big catalyst and no panic. Thus, my best guess is that if the "taper talk" hadn't come along, we might have seen a rather dull, sideways consolidation that lasted a month or three.

But instead, we were treated to all the hysterics surrounding the Fed's talk of tapering their QE program. In response, the S&P dove 4.8% in 4 days. However, thanks to an abundance of dovish Fedspeak, the premise for the quick dance to the downside has been called into question. So, given that the majority of the decline could be put in the emotional/freak-out category, I'll argue that a "V" bottom is a likely outcome.

In terms of what we should expect from here for the "V" case... If history is our guide, we won't see a retest of the lows; near-term support will hold; the dips will be bought; and the bulls can be expected to win the important technical battles. In other words, the market will stair-step its way higher and will skip the retest.

So, what's the bottom line here - will we see "V" or "W"? My best guess is we will see some sort of a combination of the "V" and the "W". I wouldn't at all be surprised if the algos come up with a reason to "flush" the market lower in the coming days in a fashion that could technically be considered a retest. However, volatility and algos aside, I'd be betting that we'll see a "V" bottom - but, of course, I'd also have an exit strategy in hand before I made that bet.

Turning to this morning...

For the first time in 2013, it looks like the major indices are going to finish lower for a calendar month. However, the bulls are on a roll at the moment, so anything is possible I guess. The question for today in the U.S. is which lead traders will follow. Will our markets go the route of Asia where the Nikkei surged 3.51% (this on top of yesterday's +2.96% gain) and China rose? Or will the algos prefer to take Europe's lead, where markets are slightly lower across the board. Or will the day turn on the economic data due to be released. Stick around, this ought to be interesting.

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The opinions and forecasts expressed herein are those of Mr. David Moenning and may not actually come to pass. Mr. Moenning’s opinions and viewpoints regarding the future of the markets should not be construed as recommendations. The analysis and information in this report and on our website is for informational purposes only. No part of the material presented in this report or on our websites is intended as an investment recommendation or investment advice. Neither the information nor any opinion expressed nor any Portfolio constitutes a solicitation to purchase or sell securities or any investment program. The opinions and forecasts expressed are those of the editors of StateoftheMarkets.com and may not actually come to pass. The opinions and viewpoints regarding the future of the markets should not be construed as recommendations of any specific security nor specific investment advice. One should always consult an investment professional before making any investment.